Financial Risk Management for InsurersOverviewFutures Contract BasicsWhat is the use of a futures contract?Differences between Forwards and FuturesDaily SettlementMargin RequirementsMargin Account ExampleMargin Account Example SolutionClearinghouseLiquidity Enhancements of Futures ContractsInterest Rate Futures ContractsT-bill FuturesT-bill Futures ValueExample of T-bill Future PriceEurodollar FuturesT-bond FuturesBefore Pricing Futures Contracts: A side commentFutures PricesCost of CarryValuation of Interest Rate FuturesForwards Prices vs. Futures PricesFutures Price BehaviorNormal BackwardationNormal ContangoUses of FuturesDetermining the Required HedgeBasisMaturity MismatchesSelecting the Best Futures ContractExampleNext time...Financial Risk Management for Insurers1. Futures Contracts2. Interest Rate FuturesOverview•What is a futures contract?•How does a futures contract differ from a forward contract?•What is the basis and what determines the relationship of the spot and futures price?•What types of interest rate futures exist?•How do we price interest rate futures?•How do we determine the best hedge?Futures Contract Basics•Similar to a forward, a future obligates one party to buy and another to sell a specified asset in the future at a price agreed on today•Futures can be cash settled or require physical delivery of underlying asset•Most contracts are closed out before maturityWhat is the use of a futures contract?•Help reduce uncertainty in future spot price•Agricultural futures were one early contract–Farmer can lock in future price of corn before harvest (protect against drop in price)–User of corn can protect against rise in price•Futures are now available on many assets–Agricultural (corn, soybeans, wheat, etc.)–Financial (interest rates, FX, and equities)–Commodities (oil, gasoline, and metals)Differences between Forwards and Futures•Features reducing credit risk–Daily settlement or mark-to-market–Margin account–Clearinghouse•Features promoting liquidity–Contract standardization–Traded on organized exchangesDaily Settlement•Recall that forward contracts have no settlement until maturity•Futures contracts settle every day–Like a series of one day forward contracts•At end of trading day, any contract value must be paid–Contract is “marked-to-market”•Risk is reduced to daily price movementMargin Requirements•Remaining risk is one day price movement•To use futures markets, party must post collateral called margin–Daily gains/losses posted to margin account•Initial margin is amount to open contract•If account balance drops below maintenance margin, customer receives margin call–If not met, customer position is closed outMargin Account Example•P/C insurer has agreed to buy ¥ 10 million through the futures market at $1.25/¥100•The following prices represent closing futures prices (per ¥100) for the next five days: $1.22, $1.23, $1.21, $1.19, $1.24•What is the value of the margin account if the initial margin is $5,000 and the maintenance margin is $3,000Margin Account Example SolutionDay Price ($/¥100) Contract Value Change in Value Margin Account0 $1.25 $125,000 - $5,0001 1.22 122,000 -3,000 2,000 (+ 3,000)2 1.23 123,000 +1,000 6,0003 1.21 121,000 -2,000 4,0004 1.18 118,000 -3,000 1,000 (+4,000)5 1.24 124,000 +6,000 11,000Clearinghouse•Even with daily settlement and margin accounts, there are default risk costs–Margin may not be enough if prices move a lot•Clearinghouse becomes counterparty to every trade–Counterparty credit analysis is not needed•Default risk is spread across the entire market•Daily price movement limitsLiquidity Enhancements of Futures Contracts•Forward contracts are negotiated by contracting parties•Futures are standardized contracts–Asset type, quantity, maturity•Futures are traded on organized exchangesInterest Rate Futures Contracts•Most popular contracts divided by the type of interest rate exposure•Short term interest futures–Treasury Bill (T-bill)–Eurodollar CD (or just Eurodollar futures)•Intermediate or long term interest futures–Treasury bond or note (T-bond or T-note)–Municipal indexT-bill Futures•At maturity, short position must deliver $1 million of T-bills with 13 weeks to maturity–Either a new issue or an existing issue•Essentially, a T-bill future can be used to hedge the future interest rate•90 or 91 day forward rate beginning at the maturity date of the futures contract•Smallest change (one tick) in value is $25T-bill Futures Value•Remember T-bills are a discount security•Index price is quoted price (in WSJ)•Invoice price is amount long position must pay to short positionIndex priceInvoice pricewhere is the yield, is the dollar discount     100 1000 000000 00091360( )$1, ,$1, ,YDD YY DdddExample of T-bill Future PriceIndex price = 94.50097,986903,13000,000,1 Price Invoice903,1336091055.000,000,1%50.5100PriceIndex 1DYdEurodollar Futures•Underlying rate is 90-day future LIBOR–London InterBank Offered Rate–Has some credit risk•Cash settled (no delivery of some financial instrument)•Most heavily traded futures contract in the world•Used to hedge future interest ratesT-bond Futures•Underlying instrument is hypothetical bond with $100,000 face value and 8% coupon•Seller has option to deliver a number of bonds at maturity•Settlement value is adjusted based on actual bond delivered•Seller will evaluate which bond is cheapest to deliverBefore Pricing Futures Contracts: A side comment•Pricing of derivatives usually uses arbitrage arguments•Arbitrage is present if:–A zero net investment can generate a non-zero cash flow (cash flow must have no uncertainty)–The return of a cash investment exceeds the risk-free rate, assuming there is no uncertainty in the returnFutures Prices•At maturity, the spot price and futures price must be equal–If not, an arbitrage opportunity exists (Why?)•Before maturity, the spot price and futures price need not be equal due to cost of carry•Cost of carry reflects the benefit or cost of holding the asset vs. the benefit or cost of using the futures marketCost of Carry•Holding the asset–We must pay storage and insurance costs•Using futures–We earn interest on our money until maturity•For commodities: Ft(1+rf)<P0+c, where c is the storage and insurance costs•If inequality goes is